Study of Causality, Shocks, and Risk Return Trade-off in Multifactor Asset Pricing Models

Abstract

In this study, attempts are made to understand the causality of factors, lead lag relationship, impact of measured shocks on returns, and predictive ability of multifactor models in volatile moments using vector auto regression, impulse response function, and generalized autoregressive conditional heteroskedasticity-mean tests. Findings only favor the market premium in Granger is causing the returns of double-sorted portfolios and momentum portfolios at 12 lags. The perseverance of shocks of double-sorted portfolios and momentum portfolios are short lived. Risk return trade-off is also preserved only in 30% portfolios of the test assets. Results are of high importance for portfolio managers, retail and institutional investors, and regulators to avoid the risk emanating from risk on/off phenomenon.

Keywords: Asset Pricing Models; Granger Causality; Risk on/off

Australian Academy of Accounting and Finance Review, vol 3, issue 1, January 2017, pp 21-27